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10 Jan 2009, 14:32

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Most of you on the forums know me as pretty focused on getting an IB job. However, my real long-term goal has always been to be either in private equity or be an entrepeneur (i.e. run a company or companies and have equity stakes in them). I have been enlightened by egy to an investment vehicle that has been in use over the past couple of decades, but does not receive very much glamour or exposure - it is the search fund. To quote wikipedia:

Search Funds are vehicles for entrepreneurs to raise funds from investors interested in making private equity investments.

In the first stage, a small group of investors back operating manager(s) to search for a target company to acquire. A fund may or may not find a target acquisition company. Investors are able to invest a pro-rata share in the target company, subject to their individual liking.

In the second stage, the General Manager(s) of the Search Fund take operating roles in the acquired company—CEO, President and the like.

Search Funds typically target companies in the $5 million to 30 million price range, requiring $2 million to $10 million of equity capital, in fragmented industries, with sustainable market positions, histories of stable cash flows, and long term opportunities for improvement and growth. Service and light manufacturing companies outside high tech industries are popular targets. Often these companies are under-managed prior to the acquisition.

Most Search Funds are started by entrepreneurs with limited operational experience and possibly no direct experience in the target industry. The goal of the investor is to place promising, motivated managers in an environment with a high probability for success given the oversight and experience of the investors themselves.

The origins of the Search Fund are often traced back to H. Irving Grousbeck, a professor at Stanford University's Graduate School of Business, who originated the concept in 1984. Since then, it is estimated that over 70 funds have been formed, with 12 operating currently. The bulk of successful Search Funds have been raised by alumni of elite MBA programs with access to strong private equity networks (e.g., Harvard Business School, Wharton and Stanford Business School).[1]

There are obviously a lot of risks involved with this model, but the rewards are also great. It is almost like "entrepeneurship-lite" - not quite as risky, but also not quite as rewarding. If you fail to find a company to acquire within the 2 year search period, you have basically thrown away 2 prime years of your career, and you have probably also foregone the opportunity to ever be in something like investment banking or consulting (with a stable pay package and career path). Also, the pay-off for this is very long-term. You will have a below-market salary during the search period (likely $70-80K your first 2 years out of school), and probably nothing too glamorous as the CEO either. However, you would receive an equity stake in the company (likely ~30%) and could stand to profit hugely upon the sale of the company. The most prolific success story is probably Kevin Taweel and Jim Ellis (Stanford GSB graduates) who purchased an $8 million dispatch company called Road Runner in 1995. Today, it is a billion dollar revenues company named Asurion.

You may be asking - why in the world would investors trust a fresh MBA graduate to become CEO of a company? I think the prevailing thought process is this: Let's say you're a venture capitalist. Venture capital investments tend to target risky industries, products, or markets, but they have experienced management teams with industry expertise. Search fund investments are the other way around - they target stable, mature markets and industries with low chances for failure, but put in a risky manager who will likely shake things up a bit. In both cases, you have the guidance of the investors as members of the board of directors, etc. to help you keep things on track.

I plan to look into this path quite a bit once I receive my acceptance to a top MBA program. If anyone else would like to discuss it as well, feel free to shoot me a PM or post here.

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12 Jan 2009, 19:11

You're welcome.

As I think about this model a bit more, I believe it hits on 2 things that MBAs are criticized for:

1) MBAs are generally risk-averse, and this is a risky proposition

2) MBAs generally fly like birds to whatever industry is "sexy" and whatever industry everyone else is flocking to. Look at the formation of all of the alternative energy clubs on various business school campuses over the past year or two for evidence of that. This model looks to exploit industries that are extremely unsexy and often poorly managed (think document management companies, liquid waste disposal companies, etc.)

Below are a couple of financial models that I have found that illustrate the search fund model. Obviously, these are based on the past few years, where cheap debt was readily available and everyone was trying to get their hands on as much leverage as possible. Still, it is pretty shocking that in the pessimistic case scenario, the new MBAs are essentially slightly damaging the company (flat revenue growth, not keeping up with inflation), and they still stand to profit from it and generate a nice return for their investors.

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13 Jan 2009, 17:24

I haven't run into too many of these funds, however, my brother-in-law's company was bought by one fund (one Tuck guy and one HBS guy.) It was a small company and the owner wanted a partial exit but to still be involved with the company. The fund guys didn't get along well with the established mgt team, and had a potential mutiny on their hands from the top salesman threatening to jump ship (incl. my bro-in-law.) It's been a disaster for them, and I think highlights the fact that just b/c you have a top-flight MBA and can scrap some capital together, doesn't make you a good business leader.

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13 Jan 2009, 17:32

cougarblue wrote:

I haven't run into too many of these funds, however, my brother-in-law's company was bought by one fund (one Tuck guy and one HBS guy.) It was a small company and the owner wanted a partial exit but to still be involved with the company. The fund guys didn't get along well with the established mgt team, and had a potential mutiny on their hands from the top salesman threatening to jump ship (incl. my bro-in-law.) It's been a disaster for them, and I think highlights the fact that just b/c you have a top-flight MBA and can scrap some capital together, doesn't make you a good business leader.

Haha wow. I've been speaking to my father a lot about the idea, and I just spoke to him an hour ago. He mentioned the exact same thing you did. If sales/operations/management people leave, the company will be destroyed very quickly, and it is very, very easy for a bunch of early 30s fresh MBAs to piss off all sorts of people.

Any idea what the conflicts were over? I really thought that this happens in a small minority of cases (especially if the old CEO is still around).

Lastly, any idea how much the financial performance has been impacted or is expected to be impacted? I think people related conflicts are part of any business and just need to be accounted for. But has the ship completely tanked or is it still sailing on course after hitting some rough waters?
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15 Jan 2009, 14:34

agold wrote:

cougarblue wrote:

I haven't run into too many of these funds, however, my brother-in-law's company was bought by one fund (one Tuck guy and one HBS guy.) It was a small company and the owner wanted a partial exit but to still be involved with the company. The fund guys didn't get along well with the established mgt team, and had a potential mutiny on their hands from the top salesman threatening to jump ship (incl. my bro-in-law.) It's been a disaster for them, and I think highlights the fact that just b/c you have a top-flight MBA and can scrap some capital together, doesn't make you a good business leader.

Haha wow. I've been speaking to my father a lot about the idea, and I just spoke to him an hour ago. He mentioned the exact same thing you did. If sales/operations/management people leave, the company will be destroyed very quickly, and it is very, very easy for a bunch of early 30s fresh MBAs to piss off all sorts of people.

Any idea what the conflicts were over? I really thought that this happens in a small minority of cases (especially if the old CEO is still around).

Lastly, any idea how much the financial performance has been impacted or is expected to be impacted? I think people related conflicts are part of any business and just need to be accounted for. But has the ship completely tanked or is it still sailing on course after hitting some rough waters?

I don't know the exact details, but when it comes to your sales force, they're loyal to one thing...commissions. You don't want to underestimate the likelihood of peopling jumping ship when mgt puts in different policies, especially if they affect the employee's bottom line. After all, how many I-Bankers when faced w/ 50% bonus decreases all threaten to jump ship?

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15 Jan 2009, 14:44

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Actually, it shouldnt be a big deal The Tuck and HBS guys were obviously dumb if they are in that predicament. Even before u buy a small business, u sign the main guys on a contract which typically extends to 5 years. Also, buying a service sector firm like a consulting company is never a good idea. If the biggest asset u own are few key personnel, then u r asking for trouble. U would rather buy companies that have marketable goods or services like construction equipment that someone just cant start by himself by leaving the company.

Probably, the guys from Tuck and HBS were trigger happy and pounced on the 1st deal they could get.
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15 Jan 2009, 14:48

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I agree. They are really stupid to play around with salesforce compensation structures. The last thing you want to change is compensation for anyone - especially if you are that 30 year old hotshot messing around with people's comp who are 20 years older than you.

But given that you're not a total idiot and don't mess with compensation - how big are the risks? Do simple personality clashes or jealousy topple over a company, if everyone is still making good money and being compensated like they have been?

If you're an empathetic leader who listens to his employees, pays them just as they have been paid in the past, involves them in the decision-making process -- is there much of a risk that just pure age will single you out?
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15 Jan 2009, 15:30

I can only speak abt my industry. Since I work in the consulting services business, and most companies are small sized (10-20 million revene), takeovers and company sales are fairly common. As long as u dont make radical changes, I dont think ur age would be an issue. The key is to keep the senior employees engaged. Also, maintaining the same level of compensation and benefits structure as before is quite important. I know some companies where people got fired for one reason or the other. That is expected. But u dont wanna deal unfairly with the employees retained after the ownership change.

agold wrote:

I agree. They are really stupid to play around with salesforce compensation structures. The last thing you want to change is compensation for anyone - especially if you are that 30 year old hotshot messing around with people's comp who are 20 years older than you.

But given that you're not a total idiot and don't mess with compensation - how big are the risks? Do simple personality clashes or jealousy topple over a company, if everyone is still making good money and being compensated like they have been?

If you're an empathetic leader who listens to his employees, pays them just as they have been paid in the past, involves them in the decision-making process -- is there much of a risk that just pure age will single you out?

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15 Jan 2009, 20:51

traffix wrote:

Actually, it shouldnt be a big deal The Tuck and HBS guys were obviously dumb if they are in that predicament. Even before u buy a small business, u sign the main guys on a contract which typically extends to 5 years. Also, buying a service sector firm like a consulting company is never a good idea. If the biggest asset u own are few key personnel, then u r asking for trouble. U would rather buy companies that have marketable goods or services like construction equipment that someone just cant start by himself by leaving the company.

Probably, the guys from Tuck and HBS were trigger happy and pounced on the 1st deal they could get.

They signed an employment agreement w/ the former CEO (founder's son) to stay on, but obviously in a reduced role. It was the middle management that had the issues, and you can't exactly sign those people (nor would you necessarily want to) to 5 year employment agreements. In my experience, and I've looked at buying a fair number of small companies, the smaller a company is, the more careful you have to be with politics and personality with leadership. When things are going well, this might not play out as much, but you throw in some stress to the system and it can really hit the fan, and in a Search Fund type of structure, you REALLY can't afford to go to zero.